History Suggests American Eagle Is A Buy, But History May Not Repeat Itself
2022.06.13 13:06
It doesn’t take a seasoned technical analyst to see the long-term chart of American Eagle Outfitters (NYSE:AEO) as bullish:
American Eagle Monthly
When shares of AEO—the clothing, accessories, and personal care product retailer—dip below Friday’s close of $11.92, history says the stock is a buy. And it’s not just history: at the moment, there are seemingly strong fundamental and qualitative arguments for shares as well.
But to twist an old market saw, this time may be different. American Eagle’s profit margins look set for a potentially steep decline, the macroeconomic environment is at risk of deteriorating and the retailer’s balance sheet isn’t quite as strong.
Taking the long view, AEO stock still has some promise. But, despite what the chart says, even at $12 there’s likely no need to rush in just yet.
The Fiscal 2021 Spike
2021 was a big year for retailers—perhaps surprisingly so. One passage from American Eagle’s fiscal fourth quarter 2021 report (ending Jan. 29 of this year) shows how beneficial the environment was:
Gross profit of $2.0 billion rose 73% from $1.1 billion in fiscal 2020. Gross margin expansion was driven by strong product demand, higher full-priced sales, lower promotions, rent savings, customer delivery efficiencies, and inventory optimization initiatives.
It’s worth unpacking the drivers of the stunning increase in gross profit dollars year-over-year. “Strong product demand” perhaps seems strange in the context of the coronavirus pandemic. It might suggest that American Eagle did a particularly good job of creating that demand through attractive assortments.
But retailers as a whole did well last year, even accounting for an easy comparison against a difficult 2020. After all, the pandemic still lingered, particularly during the first half of the year. Consumers were flush with cash, owing to both stimulus payments and, in many cases, sharply reduced spending on travel and experiences.
That demand meant American Eagle had to offer fewer promotions to drive sales. It also meant that competitors did the same, sharply reducing the intense discounting that had marked the industry before the pandemic. More full-priced sales mean higher gross margins. Rent savings and more efficient delivery—created in part by higher online revenue—further improved operating margins.
In fiscal 2019, American Eagle posted gross margins of 35.3%. In FY21, the figure was 39.7%. The 440 basis point difference is huge for a retailer, and it led to a steep expansion in operating margins as well.
American Eagle’s operating margins in FY19 were only 7.3%; they were 12% two years later. As a result, even with interest expense incurred on convertible debt incurred at the onset of the pandemic, adjusted earnings per share soared. Adjusted EPS was $1.48 in FY19, after years of minimal growth. In FY21, American Eagle’s adjusted EPS was $2.19, nearly 50% higher.
Margins Are Headed South
The problem, however, is that 12% margins are unsustainable. The promotional environment that dominated the industry—and kept a lid on retail stocks—during the second half of the 2010s is on its way back. Target (NYSE:TGT) already has warned on earnings twice; as Thomas Hughes wrote, “the age of full-priced selling, reduced promotional activity, and widening margins is over.”
Target stock has been crushed by its lowered guidance and fears about its inventory, which increased 43% year-over-year in the first quarter. American Eagle Outfitters’ inventory rose 34% during the same stretch. Unsurprisingly, like Target, American Eagle slashed its operating profit outlook.
After Q4, AEO guided for $550 million to $600 million in operating profit, suggesting margins still above 10%. After Q1, the company said only that its earnings would be above the $314 million achieved in FY19. That in turn suggests margins back around the 7% level seen three years ago, and maybe worse.
Again, as Hughes wrote, the age of full-priced selling is over. Instead, the new American Eagle looks like the old American Eagle—at best.
The Case for AEO Stock
To be fair, simply being the old American Eagle might be good enough. AEO stock was near $15 at the beginning of 2020. And before that, investors generally stepped in around current levels.
Meanwhile, shares now trade at less than 9x this year’s consensus EPS estimate, and the stock yields a healthy 6%. There’s certainly a case that the new normal is priced in—and then some.
It’s not a terrible argument. Retail does look challenging in general, but few concepts are as strong as AEO’s Aerie brand. Aerie has generated $1.4 billion over the past four quarters, with a mid-term management target of $2 billion. American Eagle has an enterprise value of just $2.3 billion, or 1.6x Aerie revenue. There’s an argument (an argument that’s probably too optimistic, but still in the range of reasonable) that investors are getting the American Eagle brand for free, or at least something close.
But there is one notable difference between AEO at $12 in 2022 and the stock at $12 in 2020, or 2017, or 2014: the economy. 2020 did see a recession, but it was the shortest one ever. That aside, the macro environment was in AEO’s favor.
That’s hardly guaranteed to be the case this time around. Inflation is an obvious problem. The inventory pile-up and concurrent strong demand for travel and experiences suggest that consumers would prefer to spend on doing things rather than owning things. Indeed, after the past 24 months, they likely own more than enough.
If the economy turns, or even if spending on retail goods simply stays soft, a cheap stock price isn’t going to be enough. More importantly, the stock price isn’t going to look all that cheap. Again, with management estimating margins in the range of 7% this year, a simple 100 basis points of additional pressure drops earnings per share by nearly 20% (as interest costs are fixed). The price-to-earnings multiple here thus moves to about 11x—in the range of where AEO generally traded before the pandemic.
So it’s possible the market overshot here. It’s possible that investors once again step in at these levels. But this isn’t a sell-off driven simply by a nervous market, or one that has left AEO stock at a valuation that makes no sense. There are real challenges here, and 7% operating margins suggest little cushion for managing those challenges. This time indeed might be different.
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